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Suppose you are in the middle tax bracket. The rate of tax you would pay on your profits from buying and selling units in an equity mutual fund, for example, would be about 22 percent. So in order to earn a better after-tax return than the 8 percent you would earn by paying off some or all of your mortgage, you would have to find an equity fund that paid around 11 percent. The reason is that after paying taxes of around 22 percent on your share of the fund's capital gains, you would be left with a return of around the same 8 percent mark.
While many funds do provide investors with returns that high, they typically aren't able to sustain that kind of performance year after year. And you'll have to expose yourself to the possibility of your investment plunging in value if the stock markets take a dive, or if the manager of your fund just happens to lose his stock-picking smarts. Paying down your mortgage is a 100-percent guaranteed return.
Chapter 3: Investing Prerequisites
Make your mortgage interest taie deductible
If you have some extra money on hand and don't know whether you should pay down your mortgage or put it into an attractive investment, there is a way to do both at the same time. When you pay off some of your mortgage, you create more equity — the paid-off part of your home. You can usually use the difference between what you owe on your mortgage and 25 percent of your property's market value as the security for a loan. Say your home is worth $200,000, and you make a lump sum payment that reduces your mortgage to $100,000. You then have $50,000 of equity in your home that can be used as collateral for a line of credit. A line of credit is similar to a loan, except that you can borrow different amounts on it whenever you need the money. Because real assets back or secure the loan, the interest rate is usually at or close to the banks' prime rate — the rate they charge their best customers. Also, as long as you make the minimum monthly repayments required by your lender, you are usually free to pay back some or all of your borrowings at any time.
Interest on money you borrow in order to buy investments or earn business income is usually tax-deductible. Suppose you have $10,000 that you use to pay down your mortgage. If you then borrow the money back, with your home as security on the loan, your interest rate might be around 7 percent, for an annual cost of $700. The investment that you buy with your $10,000, though, earns you $1,000 — a 10 percent return. From the tax department's perspective, you have only made a net profit of $300, or 3 percent (10 percent - 7 percent). You'll have to pay capital gains tax on two-thirds of your profits, namely 2 percent. If you are in the middle tax bracket, the end result is that you make 2 percent after tax on your investment, even after paying the cost of borrowing the money.
Besides the most common reason of lacking the funds to do so, other good reasons not to pay off your mortgage any quicker than necessary include the
j-' You contribute to your RRSP instead. Paying off your mortgage faster has no tax benefit. By contrast, putting additional money into an RRSP can immediately reduce your federal and provincial income tax burdens. The more years you have until retirement, the greater the benefit you receive if you invest in your RRSP.
>■ s You’re willing to invest in more growth-oriented, volatile investments, such as stocks and real estate. In order for you to have a reasonable chance of earning more on your investments than it costs you to borrow on your mortgage, you must be very aggressive with your investments. As we discuss in Chapter 2, stocks and real estate have produced annual average rates of return of about 8 to 10 percent. You can earn even more with your own small business or investing in others' businesses. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry. Remember that you have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.
Part I: Investing Fundamentals
Paying down the mortgage depletes your emergency reserves.
Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don't want to pay down your debt if doing so depletes your financial safety cushion. Make sure that you have access — through a money market fund or other sources (a family member, for example) — to at least three months' living expenses. Of course, you could pay down your mortgage and then arrange for a line of credit using the paid off value of your home as collateral. Essentially, you use the equity in your home as the security for the ability to borrow from your bank or trust company up to a predetermined limit, if and when you should need to.
Finally, don't be tripped up by the misconception that somehow you'll harm yourself more by a real estate market crash if you pay down your mortgage. (Tony actually had a university economics professor take him to task over just this point, saying that paying down a mortgage was bad advice not only because of the supposed extra risk due to a market downturn, but because it meant less diversification. Shows that having a few academic initials after your name doesn't necessarily mean you know what you are talking about!)